blockchain is eating software, the internet, data and the world.

​and it's hungry for seconds.

​On September 18, the Office of the New York State Attorney General (the "Office") released a report following a crypto exchange initiative it began several months prior. The Office has been liaising with crypto exchanges to learn more about the current state of digital asset platforms.

The most notable takeaway is the three areas of concern that the report discusses:

Conflicts of Interest

The report outlined many worrisome conflicts of interest. Exchanges often have several lines of business (e.g. acting as an exchange and a broker-dealer) that pose conflicts of interest, which would be prohibited or monitored if they were traditional exchanges. Additionally, employees of these exchanges may have access to non-public information.

One concerning conflict that the report discusses is that exchanges often trade in their own proprietary accounts (i.e. an exchange buys/sells crypto that it holds in its own account). This should be worrisome for investors because it means exchanges may be artificially affecting crypto liquidity and prices.

Abuse Safeguards

Exchanges do not have consistent safeguards in place (e.g. effective trade monitoring), and there currently is no way to monitor suspicious trades across exchanges. Few exchanges restrict or monitor the use of bots. The Office noted that these risks leave exchanges vulnerable to abuse like price manipulation, and only a few crypto exchanges have taken meaningful measures to mitigate these kinds of risks.

Customer Protections Are Limited

Exchanges don't currently have consistent auditing standards for the crypto they have custody over, and a few noted that they don't have an independent audit done at all. This makes it difficult to gauge whether crypto exchanges adequately protect the crypto they hold, especially in light of the significant risks exchanges face (e.g. possible hacks). The Office also questioned the adequacy of any insurance an exchange may have (or lack completely).

Take Away

The concerns mentioned may stem from the lack of standards in the industry, not necessarily from insufficiency; it's hard to evaluate something with no guiding principles. The NY report doesn't raise particularly novel issues, but it does show that crypto exchanges have their work cut out for them.

***

Reginald Young is a licensed attorney in San Francisco, California, where he works with private investment funds and startups in the crypto industry. You can connect with him here. ​

Chairman Jay Clayton of the Securities and Exchange Commission ("SEC") recently made some comments that could have significant impacts for crypto and securities regulations. These statements, made at the August 29 Nashville 36|38 Entrepreneurship Festival, seem to have been missed by many.

ICOs

Chairman Clayton began his speech saying that “[n]o conversation about recent efforts at the SEC to foster innovation would be complete without mentioning our approach to distributed ledger technology, digital assets, and [initial coin offerings ("ICOs")].”

He gave a short overview urging caution for investors in the ICO space, but made this short comment in passing:

“Bill [Hinman] recently outlined the approach the staff takes to evaluate whether a digital asset is a security, and I strongly encourage you to take a look at Bill’s speech.”

Translation: Clayton endorsed the analysis that SEC Division of Corporation Finance Director, William Hinman, made in his June 4 speech at the Yahoo Finance All Markets Summit. You know - the talk where he said Ethereum probably isn’t a security. Which is significant in ways most haven’t appreciated yet. You can read about the significance of Director Hinman’s comments here, but, in many ways, Director Hinman’s comments were the first recognition that there is a new “digital asset” class.*

In even simpler terms: Chairman Clayton arguably endorsed Director Hinman’s statements and analysis that Ethereum is not a security.

Private Offerings

The other significant comment that Chairman Clayton made was that the SEC needs to rethink the current offering exemption framework. Generally, sales of securities in the US must be registered or qualify for an exemption. Right now, one of the most commonly used exemptions is for private offerings, which often requires that an investor is “accredited” (aka, has more than $2.1MM in net worth, or regularly earns $100k in annual income).

Chairman Clayton generally outlined how the SEC should approach rethinking the exemptions, but he makes a particularly interesting comment:

“We also should consider whether current rules that limit who can invest in certain offerings should be expanded to focus on the sophistication of the investor, the amount of the investment, or other criteria rather than just the wealth of the investor.”

Aka, maybe it’s time to re-think the “accredited investor” requirement and open up the private offering exemption to more people.

The ICO ecosystem was partially built on a frustration that only the wealthy can access good investments due to the accredited investor threshold. Of course, these kinds of restrictions are meant to protect everyday mom-and-pop investors who can’t (or shouldn’t) take the risk of being misled to invest in something like Bitconnect. But now that crypto is waking up the reality that a lot of tokens are securities, expanding private offering exemptions would open the floodgates for capital to flow into crypto, and fuel the ICO market even more.

We’ve already seen some attempts to open up the offering exemptions. For example, one of the exemptions in Reg A+ looks at the amount an investor invests relative to his or her overall income or net worth. Reg CF similarly looks at an investors income and net worth, but doesn't outright ban investors under $100k; instead, it just limits how much they can invest relative to their income or net worth.

So the trend towards softening the "accredited investor" requirements has been brewing for a while, but Chairman Clayton's comments sound like the SEC is ready to revamp the whole framework in a way that could open up capital formation for private companies a lot more.

Takeaway

TL;DR: the Chairman of the SEC arguably endorsed that Ethereum is not a security, and that the timing is ripe to rethink private offering requirements like "accredited investor" status. Both of these are good news for the future of crypto.

**

Reginald Young is a licensed attorney in California, where he works with private investment funds and startups in the crypto industry. You can connect with him here. ​

**

*Recent regulatory trends increasingly suggest that crypto may correctly be imagined, generally, as: (i) “currency” tokens like Bitcoin, that are meant to function entirely as digital money and are not securities; (ii) “digital assets” like Ethereum that have utilitarian functions in addition to or instead of currency functions, and may be securities; and (iii) security tokens that are, in essence, tokenized forms of equity or ownership. Of course, this is a simplification and you can add additional categories and subcategories. But it illustrates the point that Director Hinman’s comments may be viewed as the first recognition that the second category (“digital assets”) may be a new asset class of potential non-securities.

One of the biggest problems facing the digital asset industry currently is custody. But what does that exactly mean?

Custody, Generally

“Custody” means what you would expect – how something is held or kept safe.

Most existing ways to "custody" or hold crypto are imperfect. Hot storage (i.e. crypto wallets that are connected to the internet) can be hacked. Cold storage (i.e. crypto wallets that are not connected to the internet) requires protecting and maintaining the hardware. Storing your Bitcoin or Ethereum on Coinbase is probably safer than storing it on a computer in your basement but, á la Nick Szabo, trusted third parties are security holes.

Better yet – any trusted humans are security holes.

No solution will ever be perfect, and there are increasingly better options like multisig wallets (i.e. wallets that require multiple private keys to access them). But, compared to the traditional securities world, crypto custody lacks standards, transparency, and is young and untested. All of those factors create a very uncertain future. What will custody look like in six months? Are multisig wallets really that safe? What would “institutional grade” cold storage look like?

Why Custody Matters

The uncertain state of custody has become a big bottleneck in the growth and adoption of digital assets. Institutional investment firms have duties to their investors. Family offices aren’t as risk seeking. These types of investors can bring significant capital to the cryptoscape, but they won't risk making investments if how those investments are custodied is uncertain. The best standards today may be easily hackable tomorrow. Time will ease custody concerns, but we just don’t have the certainty the industry needs yet.

Qualified Custodians

Another good example is the “qualified custodian” requirement for certain investment advisers. For example, investment advisers (think: hedge fund manager) that are required to register with the SEC (aka, they have more than $150MM in assets under management) must hold assets with a “qualified custodian”.

The term “Qualified Custodian” (“QC”) is defined in Rule 206(4)-2 of the Investment Advisers Act of 1940. It generally means a bank or savings association with FDIC insured deposits, a registered broker-dealer, a registered futures commission merchant, or foreign institution that typically acts in a similar custody role.

In simple terms: a qualified custodian is usually an entity like a bank, that is subject to robust regulation and compliance requirements.

As of the date of writing, only Kingdom Trust is the only self-advertised crypto QC (but there is some debate on whether it actually is a qualified custodian, which means there may not actually be any QCs). But even then, Kingdom Trust's offerings are limited to crypto like Bitcoin, Ethereum, and ZCash.

Many institutional investors are staying out of crypto because they have to hold assets with a QC...but there aren't great QC options right now (in fact, there may not actually be any options). However, there are lots of promising efforts underway, like those by Coinbase and BitGo.

Startups

Custody also matters for crypto startups. They need think about how they should properly custody tokens in an industry without clear standards. Exchanges need to have sufficient protocols and protections in place to protect assets, and need to account for situations like how tokens will be held in bankruptcy.

Time Will Tell

The standards for crypto custody will become clearer over time, but they’re something the industry needs to focus on and develop. Recent developments are promising, however. For example, the Winklevosses (…Winkevai?) have gotten support from a CFTC commissioner for their proposed self-regulatory organization, which would help establish regulatory standards for the crypto industry.

**​Reginald Young is a licensed attorney in California, where he works with private investment funds and startups in the crypto industry. You can connect with him here.

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